DEALBOOK; Europe's Air and Military Companies in Merger Talks

By NICOLA CLARK

Published: September 13, 2012

8:28 p.m. | Updated

PARIS - The two biggest European aerospace and defense companies said they were in discussions about a potential merger that would create an industry behemoth with a combined market value of nearly $50 billion.

EADS, which is the parent of Airbus, and BAE Systems are looking to join forces as their respective industries become increasingly competitive. While government contracts provide steady revenues, large European countries and the United States are pulling back on their military spending, weighing on the prospects of BAE Systems. Passenger airlines, the main customers of Airbus, have perked up lately, after some difficult periods.

"They are complementary businesses," said Richard Aboulafia, an aerospace analyst at the Teal Group. "This is a way of achieving balance from the defense side."

The two companies seem to be taking their cues from competitors.

With its acquisition of McDonnell Douglas in 1997, Boeing sought a more reliable income stream to offset the boom-and-bust cycles in passenger travel. After the terrorist attacks in 2001, Boeing's rapidly growing military business helped buffer it from a collapse in the demand for passenger jets.

The dynamic has shifted over the last several years. Boeing's commercial business has soared while its military operations have been hampered by budget cuts in many countries. BAE, which is primarily a military company, is facing the same belt-tightening in its main markets, as Airbus has experienced a surge in orders.

The merger would help the companies better weather such volatility. Currently, Airbus represents about 65 percent of EADS revenue; after the deal, commercial aerospace would account for 53 percent of revenue with 47 percent coming from military and security, said one person familiar with the details who spoke on condition of anonymity because the talks were continuing.

The combined company would also rival Boeing. Annual sales at the two companies topped $96 billion in 2011. Boeing's revenue was nearly $70 billion last year.

"On the face of it this will create one of the largest aerospace and defense organizations on the planet," said Guy Anderson, a senior defense industry analyst with IHS Jane's in London, who added that the combination would "change the European defense market beyond recognition."

Shares of BAE Systems rose 10.8 percent by the end of trading in London on Wednesday, while shares of EADS were down 5.6 percent.

BAE and EADS (for European Aeronautic Defense and Space) have a history of collaboration. They are partners on a number of projects, including the Eurofighter jet. BAE also held a direct interest in the Airbus consortium for many years before selling it back to EADS in 2006.

The deal could give the two companies more lobbying muscle to compete with Boeing and other American military companies. BAE already has a strong presence in the United States, but EADS has had only limited success with American military contracts. Last year, the company lost a coveted $35 billion Air Force contract for aerial refueling tankers to Boeing. A merged EADS-BAE would most likely derive about a fifth of its sales from North America.

In a statement made to the London Stock Exchange late Wednesday, BAE said the potential combination "would create a world class international aerospace, defense and security group with substantial centers of manufacturing and technology excellence in France, Germany, Spain, the U.K. and the U.S.A."

Any deal would face its share of regulatory hurdles. The European Commission would have to approve the merger. The American government might also weigh in on the transaction. BAE's Sanders unit could especially face scrutiny. The group, which BAE acquired from Lockheed Martin in 2000, makes military electronics.

"There is no telling how much of the combined offering would have to be sold off to satisfy regulators," Mr. Anderson said.

The companies would also have to navigate the complexities of its investor base. Today, 49.35 percent of EADS's shares are owned by the public, with the French government and the German company Daimler controlling a 22.35 percent interest each and Spain a 5.45 percent interest. BAE is an aerospace institution that was once owned by the British government.

The structure of the deal could help appease shareholders. Rather than an outright merger, the parties indicate that they would enter into a dual-listed company structure. That would allow BAE to preserve its British heritage while EADS can still claim to be a Continental European company that will be owned by French, German and Spanish entities.

Other companies have taken that approach. BHP Billiton and Rio Tinto are dual-listed companies involving a British public limited company and an Australian public limited company.

Under British law, EADS and BAE have until Oct. 10 to decide whether to pursue the merger. The merger talks were reported earlier on Wednesday by Bloomberg News.

Reporting was contributed by Steven M. Davidoff and Christopher Drew from New York, and Mark Scott and Stephen Castle from London.

This is a more complete version of the story than the one that appeared in print.

PHOTO: Working on a howitzer at BAE Systems. BAE is in talks with EADS, the parent of Airbus. (PHOTOGRAPH BY DAVID MOIR/REUTERS)